Interest rate strategy
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The decisions by the European Central Bank (ECB) and the Bank of England (BoE) to indicate that low interest rates are here to stay have significant implications for markets.
The ECB briefed extensively on interest rate cuts following signs of weakness in M3 and credit flows, and Mr Draghi even went so far as to say that “50bp is not the lower bound”. By reference to key ECB interest rates, the ECB does not therefore preclude cutting the deposit rate below 0%. The Euro curve (the structure of interest rates expected through time) rallied hard after the ECB’s meeting with 5 year German yields rallying by 10bp (e.g. rates fell, prices rose).
With the ECB changing its communication strategy towards a dovish bias we can expect a small tightening bias in short-dated rates but that doesn’t mean that we should expect any imminent rate cuts by the ECB given the recent stabilisation in data. So while the ECB provides forward guidance that rates will stay low and we can expect a grind tighter in front-end spreads, with the ECB in effect tethering to very low cash rates, at the same time we can expect rates between five years and thirty years to steepen – in other words investors will seek compensation for lending long, with the expectation that easier policy now will deliver higher rates further out.
Of course, markets are in a sense taking the ECB at face value, and looking ahead, the key for us is to watch US economic data in coming weeks (US payrolls today are particularly important). The market is likely to test the ECB’s resolve on forward guidance if the European data continues to surprise positively and especially while the Fed keeps its line on tapering QE. Given this uncertainty on the extent to which the ECB can anchor the front end, we would encourage investors who want exposure to euro-denominated debt to anticipate that there will be a structural steeping of the yield curve with long rates rising relative to short rates.
With the UK, the BoE commented that the rise in interest rates as seen in the market would likely weigh on the growth outlook and specifically that “the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.”
There is therefore a clear signal that the BoE is moving towards a more dovish bias at the same time as the ECB.
The moves in the US and the liquidity-driven squeeze in the front end of the sterling cash market had pushed yields higher by over 50bp over the last month. This was excessive in advance of the arrival of Mr Carney as new BoE Governor given that he was always likely to affect the “term structure of interest rates” with a form of forward guidance. The background to market developments has been the surprising on the upside of UK economic data in the last two months – and it is reasonable to expect a modest slowdown in momentum of UK data and hence less upward pressure on front end yields.
Given uncertainty on the timing and extent of Carney’s new policies, there has been a degree of ‘wait-and-see’ and sterling Libor-Sonia spreads (so the spread between term and overnight money) widened over the last 3 months. Bizarrely spreads in the UK widened further than in USD, Europe and CHF – and this while the UK has explicit credit easing via the FLS and policymakers are contemplating forward guidance! Developments encourage the short-term view that Sterling Libor-SONIA spreads are too wide eg term deposits that discount any near term tightening are worth having) – accepting that the main risk to this opportunity is that the MPC fails to confirm its forward guidance at the August Inflation Report.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
